Are Variable Annuities a Good Investment?

The WSJ Debate

One result is increased interest in putting at least some of their retirement assets in variable annuities. Variable annuities are a tax-advantaged way of investing in stock, bond and other funds. For an additional fee, many come with guarantees of lifetime minimum income paid out even if the underlying funds tank.

Critics say these annuities are too costly. The relatively high fees annuity investors pay can eat up a significant amount of money over the long term, they say, and investors also can get more-favorable tax treatment with some other investments.

Proponents say the cost of annuities is worth it for the security they offer. No other investment, they say, can protect investors as well and still give them the chance to earn something more than a nominal return on their investment.

Ellie Lowder, a financial consultant based in Tucson, Ariz. says variable annuities are a good investment. Lewis Altfest, chief investment officer at Altfest Personal Wealth Management in New York and an associate professor of finance at Pace University, says in most cases they're not.

Yes: You'll Sleep a Lot Better

There's a fear factor in the financial markets today that variable annuities are uniquely equipped to address.

The fear comes both from the market gyrations of recent years and from uncertainty about the future.

ENLARGE

ELLIE LOWDER: 'Variable annuities offer investors reassurance about the return of their money.' St. Jude's Research Hospital

Share prices have now plunged twice since the year 2000, first when the tech bubble burst, then when the financial crisis reared its ugly head. Investors have been reminded that share prices do not always go up, and many individuals still haven't fully recovered the heavy losses they suffered during those two events.

On top of that, investors can no longer rely on what were once considered two dependable sources of at least some of their retirement income: Defined-benefit pension plans have been disappearing for years, and those that remain are either being diluted or are in danger of being diluted—if not gutted or simply shut down. And there is justifiable concern among many investors that the Social Security benefits they are expecting may be reduced as well.

All this uncertainty has changed the mind-set of many investors in a fundamental way that's captured in a quote variously attributed to Will Rogers and Mark Twain. It goes something like this: "I am not as concerned with the return on my money as I am the return of my money."

Variable annuities offer investors reassurance about the return of their money, without sacrificing the opportunity for a healthy return on their money. They give investors control over their retirement assets—an important feature when so much on the financial and economic landscape seems to be out of control.

An Attractive Package

Variable annuities are a package of products and features not to be found in combination anywhere else.

ENLARGE

The Wall Street Journal

They address the fear factor by offering guarantees of various kinds. The most prominent of these in many variable annuities is a guarantee of lifetime minimum withdrawals, so that no matter what happens in the financial markets, investors know that they will receive a certain annual income for the rest of their lives. Investors can also choose various kinds of death benefits to protect the value of their investment for their heirs.

Detractors point out that benefits like these aren't free. Investors generally pay higher fees for variable annuities than they do for other kinds of investments.

Higher fees mean lower returns, which can really make a big difference over a number of years.

People can do better, say the critics of variable annuities, by investing in lower-cost mutual funds that will provide better returns. Or, if safety is the primary concern, investors can buy certain kinds of bonds that don't offer much in the way of returns but are very unlikely to lose their value and also can be had for lower fees than an annuity.

The Safety to Take Risks

But no alternative offers the safety of a variable annuity and the potential to reap substantial returns if stocks do well. The guarantees offered by variable annuities don't preclude big gains, they just protect against big losses.

With a guarantee of a set lifetime income in hand, even an investor with little or no risk tolerance can stay invested in stocks. If share prices soar, the annuity investor reaps those returns, while bond investors can only wish they were doing so well.

Granted, the annuity investor's returns might not be as big as those of an investor who bought the same type of equity options through a 401(k), but if the markets turn suddenly—again—the annuity investor has no reason to panic and pull everything out of stocks at exactly the wrong time.

Variable annuities also generally include a feature called a fixed account, which is a portion of the money in the annuity that isn't invested in any stock-market assets and earns a fixed interest rate established by the company you buy the annuity from—basically an interest-bearing CD type of account. This pool of money can be used to buy equities using dollar-cost averaging—investing a set amount at regular intervals—which is a widely recommended strategy to help investors take advantage of the ups and downs of share prices.

Under the umbrella of the variable annuity, investors also have the ability to contribute to a variety of money managers—not just the managers available in one family of mutual funds.

As with any purchase, investors should weigh the benefits of

a particular annuity and its particular features versus their cost.

Annuity terms can be confusing, but a financial adviser can help you understand and compare what's out there. And yes, some other types of investments offer more-powerful tax benefits than annuities. But there's room in your retirement plan for both.

Don't let the annuity critics dissuade you from putting at least a portion of your savings where your comfort level is greatest.

Ms. Lowder is a retirement plan consultant based in Tucson, Ariz. She can be reached at reports@wsj.com .

No: They're Not as They Seem

Variable annuities offer the siren song of guaranteed returns and tax benefits. But when we look behind the curtain, we see that the guarantee may not be as strong as it seems and in any event may not provide much more safety than a bond—and it costs too much. Plus, the tax benefits aren't that powerful when compared with those of other investment alternatives.

What that all adds up to is this: Annuities are too costly for the benefits they provide.

Total fees for variable annuities—including the fees charged by the company that sells the annuity, those charged by the funds available to investors in the annuity, and the extra amounts that investors have to pay for the guarantees that make annuities so attractive to so many people—can come to about 4% annually. If that doesn't sound like too much, look at it this way: Fees that high can easily reduce an investor's returns by as much as 50%.

Fees can be kept down by purchasing an annuity from a no-load provider and by choosing bond funds or passively managed index funds—which generally charge lower fees than other kinds of funds—from the annuity's menu of investment options. But even with those savings, direct investment in mutual funds is cheaper, as are other alternatives.

A far better alternative to a variable annuity is to put that money into a pension plan that allows pretax dollar contributions and has lower overhead costs than an annuity. That way the investor not only sacrifices less in fees but also gains a more significant tax advantage.

Both variable annuities and so-called qualified pension plans—including 401(k)s, individual retirement accounts, defined-benefit plans and profit-sharing plans—allow an investor's money to grow tax-free and then be taxed as regular income when it is withdrawn. The difference in the tax bite comes up front, in the money the investor puts into the account. For investors in variable annuities, in most cases, that is income that has already been taxed. But the money investors put into qualified pension plans is deducted from their taxable income, resulting in a substantial additional tax benefit.

ENLARGE

Even mutual funds bought directly, outside a retirement account, are preferable to annuities, because the taxes on their dividends and capital gains can add up to less than the ordinary-income tax investors pay on withdrawals from annuities.

Nothing Is Free

Another significant issue with variable annuities is the need to read and evaluate the fine print in these contracts. One annuity we evaluated, issued by a major insurance company, guaranteed a minimum 5% annual return regardless of which investment options you selected from the annuity's menu. Who could resist that? You could invest in aggressive equity funds and get all the upside potential without concern about losing money.

We looked at the fine print on that contract and found that the guarantee would only be in effect if the variable annuity were ultimately converted into an immediate annuity. That means the investor gives up the entire amount of the account in exchange for set payments that often extend over the rest of his life. No more choosing from a menu of investment options, and the payments usually reflect a modest rate of return—currently below 4% in many cases. And generally the investor's heirs receive nothing after his death.

At the time, our client owned a $500,000 annuity that had declined to about $400,000. It became apparent that even with the $500,000 guarantee the annual payments that would be received from that company's immediate annuity were only equal to the amount that would be paid by a $400,000 policy from a low-load annuity company.

The moral is, there is no free ride in annuities. Extra benefits come with extra costs, some priced separately, others hard to calculate and compare. Even financial advisers sometimes have to take hours to fully decipher them.

Another feature that many people find attractive in a variable annuity is a guarantee that your estate will at least receive your original investment back at the time of your death, regardless of the performance of the fund. Since you may hold the annuity for 20 years or more before that happens, this is a somewhat bogus benefit, as stock-market performance has never been negative over that time frame. But you're still paying for that guarantee.

Too many people are looking into variable annuities now because they've lost money in stocks in the most recent plunge of share prices amid the financial crisis, or in past bear markets. But just when things seem particularly risky, the future for equities is brighter. In comparison with an annuity, a properly constructed, widely diversified investment portfolio adjusted for your personal tolerance for risk will serve you much better.

Dr. Altfest is chief investment officer at Altfest Personal Wealth Management in New York and an associate professor of finance at Pace University. He can be reached at reports@wsj.com .